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The Global Markets Weekly – 2/9/18
What Next After “Small Potatoes” Correction?
With trailing fundamentals solid, households upbeat, and fiscal tailwinds strengthening, improved momentum in the U.S. and global economies will remain hard to shake in 2018. So, it wasn’t unreasonable for the NY Fed’s Dudley to call market ructions “small potatoes” Thursday, though even big potatoes start out small. Many global indexes have exceeded the round-number 10% “correction” hurdle. In the U.S., if a bottom were to be found by next Friday, this would still be the shortest peak-to-trough 10%-plus correction in the postwar record, the next closest being a 20 calendar-day stretch in 1997. That suggests declines may not quite be over, notwithstanding DE’s upbeat outlook and unchanged market year-end targets.
Comparisons to the late 1990s have been in vogue, with “healthy” short drawdowns of three months or fewer in 1997, 1998, and 1999, all among the shortest on record. Other similarities in the narrative include better productivity beneath the official statistics due to technology, lower oil prices, and cyclically stronger economic growth are similar, though so are elevated valuations. The link between broad economic fundamentals and markets is useful, usually necessary but not always sufficient in assessing the outlook. They tend to lag at market turning points, e.g. GDP never contracted in y/y terms in 2001, though the S&P 500 halved.
The focus should be on whether moves feed back into confidence and spending, as current ructions haven’t tightened financial conditions sufficiently for the Fed to second-guess a March hike—the “Powell Put” is still a way off. Corporate quality spreads are an important guide, and outside high yield remain tighter YTD. Moving beyond the 10-15% correction range, or quickly to well above 3% on the 10yr might give officials pause, but DE and consensus remain firmly focused on a March hike.
Elevated valuations in historical terms are a poor guide for timing over short horizons. Dating from Fed Chair Greenspan’s December 1996 “irrational exuberance” speech, the S&P 500 outperformed aggregate U.S. bonds on a total return basis by another 19% annualized for the next three-plus years, before then underperforming by 30% annualized over the next two and half years. Complicating current pain, tailwinds in stock and bond prices have both reversed at the same time.
Ultimately, DE does expect strong fundamentals to hold in 2018/2019 while market participants adjust to the shifting rate landscape and paring back in central bank liquidity provision. DE continues to strongly favor stocks over fixed income over a 1-3 horizon, and will of course monitor any “big potatoes” on the horizon as inflation, interest rates, budget deficits, and volatility reawaken after a long period of calm.